By Fatskills Exam Guides Team — the exam nerds behind 28,500+ quizzes and 2.1M practice questions across 500+ global exams.
Risk Risk is the potential for loss. A financial risk is the type of risk with which insurance is concerned. A dynamic risk is one that is associated with changes in the economy, whether in price level or consumer tastes. Static risks are those that are more easily covered by insurance, since they pertain to common economic risks. Fundamental risks are those that are not particular to any one individual, and as such are the responsibility of society. Particular risks are felt by individuals and so are more commonly treated by insurance. A pure risk has only two possible results: loss or no loss. A speculative risk, on the other hand, has the potential for both gain and loss. An insurable risk must be definable, measurable, somewhat predictable, and must create losses that are random and not catastrophic.
Peril, Hazard, the Law of Large Numbers, and Adverse Selection A peril is a reason for loss. Perils include fire, windstorm, and theft. A hazard is some condition that is likely to increase the chance of loss in the event of peril.
There are three types of hazards: physical hazards are physical properties (like volatility) that increase hazard; moral hazards are qualities in individuals (like dishonesty) that increase the risk of loss; and morale hazards are the dangers that one faces by being indifferent to risk.
The law of large numbers states that as the number of independent trials increases, the instances of a certain event will approach the number predicted by probability. In other words, when something occurs many times, it is easier to predict aspects of it. The concept of adverse selection states that the people who are aware of their vulnerability to a certain peril are more likely to acquire insurance against it.
Response to Risk and Mortality vs. Morbidity Risk retention is the voluntary or involuntary submission to risk and is especially common in situations where potential loss seems to be small. Risk transfer is the shifting of a risk from one individual to another who is more equipped to handle it. Risk control is the process of minimizing losses, while risk financing is the process of developing the means to pay for losses. Risk reduction involves taking active steps to minimize the damage caused by risks with high frequency but low loss. Risk avoidance is the total refusal to perform a risky behavior. Mortality is the rate at which a population dies, while morbidity is the likelihood of disability. Insurance companies use the mortality and morbidity rates of certain populations to set insurance rates.
Risk Exposure Personal Life insurance is intended to allow a person’s dependents to carry on when he or she dies. There are two main ways to design it. The human life value approach determines the present value of the portion of a person’s income that will be necessary to support his or her dependents. A needs analysis, on the other hand, compares the needs that will arise after the person’s death with the means already in place to fulfill these needs. Individuals are also at risk of becoming disabled, in which case they may need insurance to cover their own cost of living. Many individuals have insurance to protect themselves against a general decline in health, unemployment, or, conversely, the problem of superannuation, in which a person lives so long that they run out of money. Property and Liability All the real estate owned by a person is at risk of many different perils, and therefore there are many insurance policies to protect real property. Other tangible and intangible assets that a person owns are also in danger of damage, and insurance policies may be taken out on them as well. Damage to automobiles is so common that the government requires drivers to take out auto insurance. As for liabilities, individuals may become subject to claims on their assets because they have been convicted of a tort. This tort may be intentional, as in the case of libel or assault, or it may be unintentional, as in the case of negligence. In either case, very few nonspecific insurance policies will cover the liabilities arising from a tort. Negligence Negligence is defined as any conduct that is below the standard of care established by the law for the protection of others against unreasonable risk of harm within the scope of reasonable expectation.
In order to prove tort liability for negligence, it must be proven that the defendant owed a duty to the plaintiff, that the defendant failed to do this duty, that the plaintiff was damaged in some way, and that the breach of duty was the cause of this damage. A person accused of negligence may use one of several defenses: that the plaintiff assumed a risk by participating in some activity; that the plaintiff contributed to the damage by risky behavior of his or her own; that their negligence was only responsible for part of the damages; or that the plaintiff had a “last clear chance” to avoid damage. Collateral Source Rule, Vicarious Liability, Libel, Slander, and Malpractice
The collateral source rule states that a person injured through the negligence of another may receive a compensation awarded in a lawsuit in addition to personal insurance compensation. A person may be guilty of vicarious liability if he or she is a principal and his or her agent commits a negligent act. Parents, for instance, are generally considered to be liable for the acts of their children. Libel is the printing of false and defamatory information about another person and is considered an intentional tort. Slander is stating out loud false and defamatory facts about another person. It is also an intentional tort. Malpractice is professional misconduct or incompetence in the performance of a professional act. The practitioner will be liable for the damages or injuries caused by malpractice. Business-Related Risk, Property and Casualty Insurance Calculation Worker's compensation laws make employers absolutely liable for injuries to employees. The death or disability of the operator or partner in a business may make it difficult for the business to continue. Homeowners insurance covers the dwelling and other structures on a replacement cost basis. This means that if the amount of insurance coverage is at least 80%, the loss will be paid without deduction for depreciation, and not on an actual cash basis, in which the payment is the replacement cost minus depreciation. If the amount of insurance is less than 80% of the replacement cost, the company will pay either the actual cash value or the proportion of the replacement cost of the loss that the amount of insurance bears to 80% of the replacement cost value of the building, whichever is larger.
Health Insurance Calculation and Life Insurance Calculation
In the calculation of health insurance, the deductible is the retained risk. If covered expenses are incurred, the first part of the expenses is applied to the deductible, which must be paid by the insured. After the deductible, the coinsurance must be paid. This is split between the insured and the insurance company. The stop-loss limit is the maximum amount that the individual can be required to pay out of pocket.
There are three factors that influence the premiums of a life insurance policy. Mortality is the probability of dying or living at a certain age. An insurance company will also calculate rates of interest, so that they do not need to collect the full amount of future losses from policyholders. Finally, insurance companies will calculate what is known as loading. Loading is the portion of the premium that will cover expenses, profit, and margin for contingencies. Mortality and interest are used to calculate the net premium, which is combined with operating expenses to figure gross expenses.
Indemnity, Insurable Interest, and Contract Requirements
Insurance contracts are said to be contracts of indemnity, because the insurer will reimburse the insured either up to the extent of the insured’s covered financial loss or the amount of coverage, whichever is less.
Typically, the insured party will be given the actual cash value of the damaged property rather than a replacement piece of property. According to the common law doctrine of subrogation, the insurer will assume whatever rights the injured party has against a responsible third party, meaning that the insurance company can sue the third party if they so choose. Insurance can only be issued if the applicant has an insurable interest in whatever is to be insured. In order for a valid contract to exist, there must be five elements: offer and acceptance, genuine assent, adequate consideration, capacity, and legality.
Insurance Contract Characteristics
Insurance contracts are specific to the person who is being insured. They are unilateral, meaning that only one party may be forced into compliance. They are also considered contracts of adhesion, meaning that the insured can only accept or reject the contract as it is written. They are also called aleatory contracts, because it is possible for one party to receive much larger benefits than the other. Insurance contracts are contracts of utmost good faith, meaning that they can be voided if one party commits fraud or misrepresentation. In an insurance contract, a warranty is a statement made by one party to another that, if false, would have the effect of voiding the contract. Concealment is the failure to disclose known information. Estoppel states that one cannot deny a fact that has already been proven. Rescission means that insurance contracts may be rescinded if one party misrepresents itself.
Categories for the Analysis of Insurance Contracts
In an insurance contract, declarations are the factual statements identifying the people, properties, and activities involved. The definitions section of the contract contains an explanation of the key policy terms. The insuring agreement is the basic premise of the insurance contract. Exclusions are those exceptions to the coverage offered by the insurer. Conditions are the things the policy owner must do in order for the contract to obtain. The policy continuation provision of the contract indicates the right of the owner to continue coverage. The valuation of losses indicates any sharing of losses that will have to be absorbed by the insured party. The endorsements and riders section contains any add-ons that the insured may obtain for an extra charge.
Property Insurance
Real and personal property consists of a person’s land, anything attached or affixed to his or her land, and the rights that are inherent in ownership. Insurance can help protect real and personal property against both named perils (in which coverage is only provided for those perils listed on the policy) and all-risk perils (in which coverage from is included for all perils unless specifically excluded).
There are eight standard homeowner forms:
HO-1, which is the basic form, for owner occupants of one- to four-family dwelling units; HO-2, the broad form, for the same; HO-3, the special form, for the same; HO-4, the contents broad form, for renters; HO-5, the comprehensive form, for owner-occupants of one to four-family dwellings; HO-6, the unit-owners form, for condo owners; HO-8, the modified coverage form, for owner-occupants of one- to four-family dwellings; and HO-15, the Homeowners Special Personal Property Coverage Form, for basic personal property.
Homeowner Forms
Homeowner forms have two major sections: the first covers property, and the second provides liability and medical payment coverage. In the first section, Coverage A insures the house and anything attached to it; Coverage B insures any other structures on the property; Coverage C insures the personal property of the owner at actual cash value; Coverage D pays for any loss of use; Coverage E insures against personal liability; and Coverage F insures for any medical payments that need to be paid to other people. This coverage is provided under the conditions that the insured must give notice to the insurance company, must protect property from further damage, must prepare an inventory of damages, and must submit a signed statement within sixty days of the loss.
Automobile Insurance
A personal auto policy (PAP) is a package insurance policy that provides both property and liability insurance for the members of a family. A PAP offers four kinds of insurance: liability coverage, which covers the people named in the policy when they are liable for damages caused by their own auto; medical coverage, in the event that the insured or anyone in the insured’s car needs medical treatment; uninsured motorist coverage, which protects drivers when they are in an accident with another driver who is not insured; and coverage for damage to the insured’s automobile. This last section contains both collision coverage, which insures against accidents with other cars, and comprehensive physical damage, which insures against every other kind of damage.
Business and Business Activity Insurance
Commercial property insurance protects real and personal property used during the course of business. Business income insurance protects individuals against a loss of income incurred after business property is damaged. Crime insurance protects businesses against losses suffered because of burglary, extortion, or employee dishonesty. Commercial general liability insurance protects the owners of a business from any claims made by customers.
Worker’s compensation and employer’s liability insurance covers employers when employees are hurt on the job, even when the injury is due to employee negligence. Commercial auto insurance covers employers for cars that are used in the everyday operations of the business.
Umbrella Insurance Policy
An umbrella insurance policy is designed to provide coverage in addition to that provided by a basic liability policy. Umbrella policies can usually only be taken out when the insured has an underlying basic liability policy. In cases where an insured party fails to maintain basic liability coverage, umbrella policies will often only pay the amount that they would have had to if a basic policy had been in place. There are a few general exclusions to umbrella liability coverage. These include owned or leased aircraft or watercraft, failure to render professional services, claims covered by worker’s compensation, intentional injury, and damage to property owned by the insured.
General Business Liability
Professional liability insurance provides coverage for the legal liability that arises when a person demonstrates incompetence in his or her profession. Professionals may take either errors or omissions insurance, which covers liability for financial and property damage, or malpractice insurance, which covers liability for bodily injury. Directors and officers liability insurance is purchased by a corporation on behalf of the officers and directors; it protects these people from lawsuits that may be brought by stockholders, creditors, competitors, and governments. Product liability insurance protects individuals against claims brought against a product that is manufactured by their business.
Health Insurance Hospital-Surgical and Major Medical
Hospital-surgical insurance policies provide benefits only when the insured needs surgery or needs to be hospitalized; in other words, they do not cover trips to the doctor’s office. These policies may not be adequate to cover long-term illness. Hospital-surgical plans often have the lowest premiums because they offer the fewest benefits. Major medical plans cover just about every kind of health condition and may provide $1 million or more in coverage. In these plans, the insured party may choose who provides their insurance, though they may receive reduced benefits if their doctor is outside a care network. One major variable in major medical plans is their coverage of prescription drugs: some plans cover all medication, while others only carry medication up to a certain point. Traditional Indemnity and Preferred Provider Organization Traditional indemnity plans provide a comprehensive medical expense plan. This includes medical, hospital, surgical, and diagnostic service. There may be a limit on the amount of reimbursement that can be received, but patients are allowed to choose their own doctor. Managed care plans are similar, though they specify which doctors may be used. Managed care plans also take more of an effort to encourage preventive care, so that customers may avoid illness. A preferred provider organization (PPO) is a benefit plan that an insurance company has established with a network of health professionals to provide health care at a reduced rate. The insured party will have incentives to use services within the network of the PPO. Health Maintenance Organization and Point-of-Service Plan A health maintenance organization (HMO) is an organized health care system that provides a range of medical services on a prepaid basis to individual subscribers, all of whom live in a particular geographic region. HMOs emphasize preventative care, though they do offer comprehensive packages of health care services. The subscribers to an HMO pay an annual premium with no deductible or co-payment. A point-of-service plan is a hybrid of the HMO and the PPO: these resemble HMOs for network services and PPOs for non-network services. Point-of-service plans may be either open-ended HMOs, in which is the insured has the option to visit doctors outside the network, or gatekeeper PPOs, in which the customer selects a primary care physician who is responsible for determining whether the customer needs to go outside the network for care. Medicare Supplement Insurance and Blue Cross and Blue Shield Medicare supplement insurance provides benefits for some of the specific expenses that are not covered by Medicare, including deductibles, coinsurance, copayments, and other expenses that are beyond Medicare coverage, like prescription drugs and treatment outside the United States. When individuals receive coverage of this kind, it is usually called Medigap coverage. The National Association of Insurance Commissioners has developed ten insurance plans for the federal government. These plans typically cover hospitalization, medical expenses, and blood. Blue Cross and Blue Shield provide for medical care for prepaying subscribers. Blue Cross plans mainly give coverage for hospital expenses, while Blue Shield plans are mainly used to cover physician’s expenses.
Disability Income Insurance Occupational Definitions and Applications If an injury or illness is not debilitating, no benefit need be paid. There are four types of disability in current policies: the inability to engage in one’s own occupation; the inability to engage in an occupation for which one has been trained or educated; the inability to engage in any occupation; and a reduction in income due to disability. Many companies use what is called a split definition of disability, meaning that they give “own occupation” coverage for a while and then modify the coverage. Many disabilities that occur on the job are covered by worker’s compensation rather than disability. Total disability benefits provide for the full policy benefit, partial benefits pay a reduced benefit if the insured can still fulfill some functions, and residual benefits help the disabled person receive a bit of extra income even after returning to work. Benefit Period, Elimination Period, and Benefit Amount Short-term disability coverage provides benefits for only a period of about six months and almost never more than a year. There may be a waiting period before the customer can receive benefits during a sickness, although there will be no waiting period after an accident. Long-term disability coverage offers extended benefits, often lasting up to two year. These policies may be subject to an even longer waiting period. The elimination period for a disability policy is just the deductible; these are used o prevent fraud by the insured. Disability benefits are structured to provide a percentage of regular earnings. Short-term disability plans typically provide benefits ranging from 50-100%, while long-term plans may range from 50-70%. Plans may have a maximum dollar amount. Riders A cost-of-living allowance allows the disability income benefit to be increased after the insured becomes disabled. A presumptive disability provision states that the loss of two limbs, or of either sight or hearing, will be treated as a total disability. A guaranteed insurability provision allows the insured party to buy additional coverage if his or her income should increase. An automatic benefit increase means the benefit will rise if the cost of the policy rises. A waiver of premium provision exists should the insured become totally disabled for a long period of time. A Social Security substitute rider allows disability insurance to be coordinated with the Social Security insurance program. A probation period is the period of time after a disability policy is issued during which certain injuries are not covered. A preexisting conditions clause acknowledges any physical condition which the insured had before coverage began. Preexisting conditions are generally not covered by disability plans. A change of occupation provision allows the insurer to reduce benefits if the insured moves to a more dangerous line of work. A relation of earnings to insurance clause states that disability benefits cannot exceed the insured’s earned income. A noncancelable policy is one that the insurer cannot cancel and in which the premiums may not be raised. A guaranteed renewable policy is one that the insurer may not cancel, but on which premiums may be raised for a whole class of policy owners. The insurer has the right to cancel a conditionally renewable policy and has total control over a policy with no provision.
Taxation of Benefits
Disability benefits received from an employer-provided disability policy are fully included in taxable income. Disability benefits received from an employee-paid disability policy are excluded from taxable income.
Disability benefits received from a policy paid by both employer and employee are included in income to the extent of the employer pro rata share of premiums. For example, if an employee pays 60% of the cost of his or her disability premium, then 40% of any disability income payments are tax-free to the employee, and 60% are taxable as income. The contributions made by the employer are deductible, but the contributions made by the employee are not tax-deductible.
Long-Term Care Insurance Policy Provisions There are special terms, like “adult day care,” that may only be used in a long-term care insurance policy if they are defined. The renewal provisions are considered guaranteed if the premiums can be adjusted and are considered noncancelable if they cannot be adjusted. Exclusions are generally prohibited, unless in the case of: alcoholism or drug addiction; mental and nervous disorder; suicide and war; and services available under Medicare or other social insurance programs. Policies must contain the right to purchase more coverage or nonforfeiture options. Inflation protection benefits must also be offered. Policies must contain a provision that waives premiums if the insured has been receiving benefits for a given amount of time. Policies cannot be contested on the grounds of misrepresentation after two years. Marketing Provisions An applicant for a long-term care insurance policy must receive an outline of coverage, a shopper’s guide, and a free 30-day period to examine the policy. The insurer must provide accurate comparisons with competing policies. The insurer must also ask clear questions when evaluating the applicant’s health. Policies cannot be issued until the applicant is given the option to identify a third party to be notified of any pending lapses because of the failure to pay premiums. Insurers must report lapse rates, replacement sales, and denied claims for each year. All of the advertisements used by the insurance company must be filed with the state regulatory authority. Contracts will have a defined period of incontestability. Eligibility The Health Insurance Portability and Accountability Act (HIPAA) created a definition for long-term care plans. HIPAA grants favorable tax treatment to qualified long-term care insurance contracts. For a contract to qualify, only long-term care insurance can be provided; the policy cannot pay for expenses reimbursed under Medicare, the policy cannot have a cash surrender value or loan provision, and any premium refunds and policy dividends must be used to reduce future premiums or increase future benefits. Qualified long-term care services, on the other hand, are defined as the necessary diagnostic, preventive, therapeutic, curing, treating, and rehabilitative services and maintenance or personal care services required by a chronically ill person and provided by a plan of care developed by a licensed health care practitioner. To be classified as chronically ill, a person must be unable to perform at least two activities of daily living (ADLs) or must require substantial help to keep healthy and safe. Activities of daily living include eating, bathing, dressing, transferring from bed to chair, using the toilet, and maintaining continence. Benefits are typically paid out a certain dollar amount per day. They may be provided on an indemnity basis that covers 80-100% of charges up to a given maximum. The duration of a long-term care policy is influenced by the elimination period and the maximum benefit period. The premium will increase proportionally to the maximum benefit period and inversely proportional to the elimination period. Elimination Protection, Inflation Protection, and Nursing Home and in-Home Care The benefits of a long-term care insurance plan do not begin until after a specified period of time during which the insured has been receiving long-term care. The cost of inflation protection is added into the initial premium, so the premiums will not increase during the annual increase. There are a few varieties of care provided for in long-term care plans: skilled-nursing care, in which a registered nurse is available at all times; intermediate care, in which less attention from nurses is required; custodial care, in which medical services are not needed; home health care, in which a person requires daily or weekly nurse visits; assisted living care, for elderly people who don’t need the care provided by nursing homes; and respite care, which is occasional full-time care provided for a person in his or her own home. Comparing Policies Consumers should make a few considerations before settling on a long-term care insurance policy. First, a policy should always be guaranteed renewable for life. Also, a three-month waiting period will usually offer the best value relative to the premium. A policy should provide coverage for skilled, intermediate, and custodial care. It may be prudent to select a policy that does not require hospitalization before entering a nursing home. It should be noted that not every policy provides coverage for Alzheimer’s disease. One should always select a policy that provides for unanticipated rises in the cost of long-term care. Finally, one should select a policy that provides for a waiver of premiums in the event of disability and that provides level premiums for life. Tax Implications and Qualification and Appropriateness of Coverage There are some excellent tax benefits of qualified long-term care contracts. For one thing, individuals are allowed to deduct a premium paid for long-term care in excess of 10% (or sometimes 7.5%) of adjusted gross income. The individual's age determines limits on the amount that can be deducted. Contributions made by an employer are deductible to the employer and will not create taxable income for the employee. Benefits are received tax-free, unless the contracts are written on a per diem basis, in which case the proceeds may be excluded from income at a rate of up to $380 a day (as of 2020). It should be noted that the young as well as the elderly sometimes require long-term care.
Automobile Insurance General Provisions Although automobile insurance contracts can vary widely, most contracts currently in effect include a few standard provisions. Most auto insurance contracts will specify that the term of the policy can only be changed or waived by an endorsement signed by the company. Also, the contract will state that the insurer will not cover any accidents or losses reported by an insured party that has made fraudulent statements. In addition, the policyholder is allowed to cancel the policy by notifying the company in writing. Finally, most contracts include a subrogation clause that applies to all coverage. Discounts and Areas of No Coverage Many insurance companies will give discounts for: higher deductibles, elimination of collision coverage for older cars, no accidents over a certain period of time, no smoking, good grades in school, completion of a defensive driving course, airbag, automatic seat belts, individuals over age 25, women, and married people. There are three main circumstances in which automobile insurance may not provide coverage. One is when a person is living in the same house as the insured but is not listed on the policy. Another common event that may not be covered is when the accident occurs during business use. Finally, auto insurance may not cover accidents that occur after the driver has rejected insurance coverage through a rental company.
Life Insurance Fundamentals All insurance policies insure not against death in general, but against untimely death. Life insurance contracts are not contracts of indemnity, as they make no attempt to restore the individual to his previous position. There are two types of life insurance. Term (or pure) insurance has no cash value; it pays a death benefit if a person dies within the term of the policy. Permanent insurance, on the other hand, never expires, has a cash value, and contains the advantage of a tax-deferred investment income. The cash value of a permanent insurance policy is a kind of savings fund for the policyholder. The level premium concept states that the cash value reserve will accumulate over time, allowing the premium to remain the same. Term Insurance There are a few different types of term life insurance policies. A yearly renewable term policy is established annually and is renewable for periods of one year. These policies typically have a fixed face amount and a premium that increases every year. Level-term insurance offers the guarantee of a fixed premium and face value for up to ten years or, sometimes, for twenty years. Decreasing-term insurance policies offer less protection every year they are maintained. This kind of insurance is often used to provide funds to pay for a mortgage. These policies usually have a fixed, level premium. Term policies offer both renewability and convertibility. Convertibility is the right to exchange a term policy for a permanent policy without demonstrating insurability. Whole Life Insurance Because the annual insurance costs in a whole life policy are spread out over the life of the insured, these policies offer a level premium. Whole life policies provide a guaranteed but fixed death benefit and a balance between cash accumulation and protection. There are four basic types of whole life insurance. Ordinary whole life has the lowest premium rate and a low cash value; it assumes that the premium rate will be payable throughout the life of the insured. Limited-pay whole life provides protection for life without forcing the insured to pay after he or she retires. Single-premium whole life is a good tax-deferred investment; it is set up with a single lump sum payment. Graded premium whole life insurance has a relatively low initial premium that increases for several years. This allows individuals who anticipate an increased income to gradually increase their payments. Universal Life Insurance Individuals who hold a universal life insurance policy may increase or decrease their benefit as long as they maintain insurability. The interest charged to the policy’s cash value is adjusted for current interest rates. Universal life insurance is referred to as unbundled insurance, because operating expenses, mortality charges, and cash buildup can all be viewed in the annual statement. Universal life insurance policies are somewhat similar to whole life policies, except that the premium payment is flexible, the death benefit is adjustable, and both the investment and the mortality risks are transferred to the policyholder from the insurance company. The cash value of a universal life policy will increase more than that of a whole life policy when the interest rates increase. Death benefits in such a policy may be paid as either the face amount of the policy or at the stated face amount plus the cash value at the time of the insured’s death.
Variable Life Insurance In a variable life insurance policy, the policy owner is allowed to choose the investments to which the savings element will be directed. There is no guaranteed cash value or crediting rate in a policy of this kind. Investments will be held in separate accounts that resemble mutual funds but are classified as different. These policies generally have between five and fifteen separate accounts from which an individual may choose; one of these is always a conservative, interest-bearing account. The holder of a variable life insurance policy runs the risk of being charged a substantial amount just to keep the policy active in a down market. A variable life insurance policy puts the investment risk on the insured party and lets him or her direct the policy’s cash value into the securities market. Only licensed insurance and securities agents can sell these policies.
Variable Whole Life Insurance and Variable Universal Life Insurance In variable whole life insurance policy, the policyholder pays the fixed premiums as in a whole life policy. There is a guaranteed death benefit, also, just as in a whole life policy. However, a variable whole life insurance policy also has the investment flexibility of a variable life insurance policy and has no guaranteed cash values. A variable universal life insurance policy has premium flexibility, just like a universal life insurance policy. Also, there is death benefit design flexibility in such a policy, just as there is in a universal life insurance policy. The differences between a variable universal life insurance policy and a universal life insurance policy are that the variable policy offers investment flexibility and has no guaranteed cash values.
Endowment Policies A less-common kind of life insurance policy is known as an endowment policy. In an endowment policy, the death benefit will be equal to the cash value at maturity. The purchaser of an endowment policy can specify the maturity date of the policy (these are usually terms of ten, fifteen, twenty, or more years). At age 100, the life insurance will be identical in design to an endowment, as cash value equals the death benefit. A change in federal income tax law made in 1984 eliminated the tax-advantaged buildup of an endowment’s cash value. The current sale of endowment contracts is very limited in the United States.
Joint-Life Insurance First-to-Die Policy and Second-to-Die Policy There are a few different kinds of joint-life policies. A first-to-die policy is usually made for the continuation of a business. The policy will insure all of the owners of the business, and when the first owner dies, the insurance company will make a payment that the other owners use to purchase the deceased’s share of the business. Second-to-die policies are more common in estate tax payment. These policies are usually purchased by married couples. When the first spouse dies, the estate transfers to the living spouse, and when he or she dies the estate is subject to a tax that the insurance policy pays. These policies tend to eliminate liquidity problems. If a deceased person owned the policy, it is included in the estate, even if the deceased is not the beneficiary. Family Income Policy and Family Life Insurance Policy There are a few different types of joint-life insurance policies. A family income policy is a combination of decreasing term insurance and some form of whole life insurance. The whole life insurance will pay a lump sum, and the term rider will provide an income designed to end at a certain date in the future. A family life insurance policy, on the other hand, has a base policy (usually whole-life) on one adult in the family. Such a policy also covers other members of the family. Policies of this kind are often sold in units; a given unit will include a certain amount of money on the primary insured, a lesser amount on the spouse, and an even lesser amount on each child.
Life Insurance Contractual Provisions There are a few contractual provisions that distinguish life insurance policies. In a participating policy, for instance, dividends may be paid to the policy owner. However, there will be a small extra margin in the premium of such policies, which will not be found in nonparticipating policies (which do not pay dividends). Also, a participating policy will be capable of responding to changes in the economy. For instance, when interest rates rise rapidly, a participating policy can adjust to give the policy owners a better chance to earn interest. An insurance contract is also declared to be a whole contract; that is, no other contract can be said to control it. An insurance contract must state that someone with an insurable interest in the insured holds the policy, and that, though the policy may be transferred, the insurance company must approve the transfer. A life insurance contract will have to state a beneficiary. The owner of the policy will have the ability to change the beneficiary unless that designation was made irrevocably. Changes must be made in writing to the insurance company in order to be effective. A primary beneficiary is the individual first designated to receive the proceeds of the policy; contingent beneficiaries are those who are entitled to receive proceeds if the primary beneficiary has died. If a life insurance contract has what is known as collateral assignment, the owner may use the policy as collateral. This arrangement is often made when life insurance is taken in a business situation. Some life insurance contracts will contain what is known as an incontestable clause. This clause gives the insurance company two years in which to discover any information about the insured that would affect the decision to issue the policy. If adverse information is discovered, the company will have the right to void the contract. Insurance contracts also contain language regarding misstatement of age: if an individual turns out to be a different age than he or she asserted at the time the policy was made, then death benefits will be adjusted to what the premium would have purchased. Life insurance contracts will also contain a statement of the grace period, an automatic extension of the period in which the premium may be paid. This period is usually 31days. Life insurance contracts contain language that indicates that if the premium is paid after the end of the grace period, the policy will lapse. A reinstatement provision allows the policyholder to reinstate a policy if insurable interest still exists and if the insured is still insurable. Reinstatement is usually automatic if it is requested within 30 days of the end of the grace period. Many life insurance contracts will contain provisions for an automatic premium loan, where the insurance company loans the individual the money for an unpaid premium automatically. This is only done in cash value policies. Some insurance contracts will contain a suicide clause stating that the insurance company must pay only cumulative premiums plus interest if the insured commits suicide within two years of the policy being issued. Life insurance contracts may contain some rather obscure provisions. An aviation and war clause denies coverage for any death that occurs during flight or war. Such policies are now very rare. A policy loan provision allows the owner to borrow money from the insurance company at a specified interest rate, using the policy as collateral. A simultaneous death clause states that if both the insured and the beneficiary die at the same time, the insurance company will assume that the beneficiary died first, and therefore will distribute the proceeds as if the insured had survived the beneficiary. In other words, proceeds will be paid to the secondary beneficiary or to the estate of the insured. Some life insurance contracts contain what is called a common disaster clause, in which the settlement of the policy proceeds is withheld for a predetermined number of days after the death of the insured and any beneficiary that dies during this period is considered to have predeceased the insured. Therefore, proceeds are distributed as if the insured had survived the beneficiary. A contract that contains a guaranteed purchase option gives the owner some protection against becoming insured by giving him or her the option to purchase more insurance at a specified later date without having to prove insurability. A waiver of premium states that if the insured should become disabled, the insurance company will waive the premiums on the life insurance policy during the continuance of the insured’s disability. The accelerated benefits provision of a life insurance contract, also known as an accelerated death benefit, allows an insured individual who is terminally ill to withdraw a portion of the policy’s death benefit before death. The portion of the death benefit that is taken out prematurely is income tax-free. There are also some provisions that are prohibited in a life insurance contract. For one thing, nonpayment of a loan is not grounds for forfeiture of the policy. Also, insurance companies cannot promise something in the declarations made about the policy and then take it away in the fine print. Dividend Options Participating life insurance policies will offer several dividend options. Dividends may be paid to the owner in cash in what is considered a return of the premium (these dividends are income tax-free). Dividends may also be paid as a reduction of premiums or treated as an accumulation of interest. This interest will then be taxed as ordinary income. Sometimes, dividends are used to purchase small amounts of permanent paid-up insurance (on which no future premiums will be due). Other times, dividends will be used to buy insurance for shorter periods of time. Finally, many insurance companies will allow the policy owner to apply the dividend to any interest or principal of a policy loan. Nonforfeiture Option The nonforfeiture option of a life insurance policy gives the owner a few choices concerning how to use the policy’s cash value. The owner may want to surrender for cash; that is, withdraw the cash value of the policy. Or, the owner may want to purchase an annuity to provide income for life or over a specified period. Additionally, the owner may want to buy a reduced amount of paid-up permanent insurance. This gives the owner a zero-premium policy of a reduced amount. Finally, the owner may want to buy the same amount of extended term insurance. This makes the amount of the term insurance the same as the face amount of the original policy, but the period of coverage will only be for the time frame identified in the policy. Settlement Options A life insurance policy will have several different settlement options. An interest-only option can be used to delay before choosing a final settlement. While this arrangement is in effect, the insurance company will send a quarterly check for interest. If a lump sum payment is chosen, no income tax is charged. A cash settlement like this allows the beneficiary to pay funeral costs, pay outstanding debts, create a fund for emergencies, and invest in the market. One common fixed annuity option (those which provide partial taxability) is the fixed income option, in which the recipient tells the insurance company how much income is needed each month, and the insurance company tells the recipient how long payments can continue at that rate. There are a few different kinds of fixed annuity options, all of which provide partial taxability. A fixed-period option is the arrangement in which the recipient tells the insurance company how long the money needs to last, and the insurance company then determines the amount for each payment. There are also four life income options. In a straight life income arrangement, the beneficiary will receive a specified amount for as long as he or she lives, but will receive nothing after his or her death. In a life income with period certain arrangement, the beneficiary is paid an income for as long as he or she lives, with a guaranteed minimum number of payments in case the beneficiary dies early. In a life income with refund settlement, the beneficiary will be paid a life income for the rest of his or her days, and if the amount of the original lump sum has not been paid out by the time he or she dies, the rest of the proceeds will be paid out to the secondary beneficiary. In a joint-and-survivor income settlement, benefits continue after the death of one beneficiary until the death of a second beneficiary. Variable annuity options can also be used in settlements. These settlements offer a return consistent with the market by investing proceeds in mutual funds. This is in contrast to a fixed annuity option, which is basically a savings account earning a fixed rate of interest. Policy Replacement A policy owner may wish to terminate or change a policy for a number of reasons. This is often done if the insurance company that issued the policy is in financial trouble, or if the policy is performing poorly. One may want to replace a policy if one has quit smoking and is now eligible for a better premium. Sometimes, people replace a short-term policy with a long-term policy if they feel they can reduce cost. An owner may want to reconsider replacement if he or she will have to pay policy acquisition costs again; if the new policy will have a new contestable period and/or suicide clause; if some of the new provisions or riders are less favorable; if the new premium will be based on the policyholder’s age at the time of the switch; or, if the savings generated by eliminating the fee from an old policy don’t offset the cost of replacement. Tax Issues and Strategies (Income Taxation of Death Proceeds) Life insurance is defined in IRC section 101(a). If a given policy doesn’t qualify as life insurance, then earnings are considered ordinary income for tax purposes. If the policy does qualify as life insurance, earnings are tax-deferred and the death benefit is income tax-free. To determine whether a policy is life insurance, the IRS usually administers either the cash value accumulation test (determining that the most that can be paid into a policy is the same as the net single premium to pay up the policy), or the guideline premium and corridor test (determining whether the ratio-to-death benefit is within a certain range). According to the transfer for value rule, income tax exclusion is lost when a life insurance policy is transferred unless it is transferred to the insured, to the insured’s corporation, or to a partner of the insured. Tax Issues and Strategies (Income Taxation of Living Proceeds) Cash buildup in a life insurance policy is not subject to taxation as long as it remains in the policy. If the cash is taken out or loaned, it is not taxable unless the policy is a modified endowment contract (MEC). A policy is a MEC if the total premium paid into the policy at any time during the seven-year testing period is more than the sum of the net level premiums that would be needed to result in a paid-up policy after seven years. If this is the case, the death benefit remains income tax-free, but the amount of the loan that is the part of the gain in the policy is taxed as ordinary income if the policy cash value exceeds the premiums paid and the policy owner borrows against the policy. MECs are subject to LIFO tax treatment with respect to loans and distributions from the company. If the policy qualifies as life insurance, it receives FIFO tax treatment. According to the IRS, dividends paid on life insurance policies are a return of the excess premium. So, if a policy owner receives dividends from an insurance company, they are not subject to income tax. The only exception to this policy occurs when the dividends exceed the cumulative premiums, in which case excess dividends must be reported as ordinary income. The taxable amount of the cash surrender is the total amount surrendered minus the policy owner’s current basis in the policy. According to IRC Section 1035 Exchange, life insurance policies or annuities can be exchanged for similar contracts without incurring any adverse income tax consequences. The basis in the old policy will simply become the basis in the new policy. Tax Issues and Strategies (Gift Taxation, Estate Taxation) When life insurance policies are transferred from one individual to another, or to a trust, there is the potential for a gift tax to be levied. The value of the policy is called the interpolated terminal reserve, which is usually very close to the cash value of the policy. The gift tax may apply in cases where a policy owned by one individual on another’s life matures because of the other person’s death, and a person other than the policy owner is named as the beneficiary. As for estate taxation, if a person owns a policy on his or her life, then the death benefit will be included in the estate for the purposes of determining whether estate taxes must be paid. Furthermore, any individuals who had an incident of ownership within the three years prior to their death will have the proceeds included in their estate. Policy Ownership Issues and Strategies There are three common ownership strategies designed to include the proceeds from a life insurance policy in the estate of the deceased. Often, if the owner of the policy is an irrevocable trust, the insured will make payments to the trust to cover premiums, so that the trust will be the beneficiary and can determine how benefits will be distributed. Another common strategy is to choose a charity to be the owner and beneficiary of the insurance policy; an annual, tax-deductible gift to the charity will cover the cost of the premium. People also often make their children the beneficiaries and owners of their life insurance policies so that they may pay the premiums without being subject to a gift tax. In split-dollar life insurance, either the employer will own the policy and have the responsibility for paying premiums (the endorsement method), or the employee will own the policy and pay the premiums (the collateral assignment method).
Viatical Agreements Legal Principles, Requirements, and Tax Implications In a viatical agreement, a terminally ill policy owner the viator) sells his or her life insurance to a third party (the viatical settlement provider) in exchange for a lump sum of cash. Typically, this lump sum is 40-80% of the death benefit. In order for this process to take place, the insured must be terminally ill or chronically ill. Also, the viatical settlement provider must be licensed with the state and must meet the requirements of the NAIC Model Act. Viatical agreements are not subject to income tax so long as the above requirements are met. If they are transferred for value, there may be some capital gains resulting from the difference between the settlement received and the total premium paid. Planning, Ethical Concepts and Planning Alternatives to setting up a viatical agreement include establishing an accelerated death benefit provision, accessing the cash value through a loan, or using the cash value as collateral to secure a loan from a bank or from someone else. The proceeds from a viatical agreement may make the viator ineligible to receive help from Medicaid or Supplemental Security Income. The proceeds may also be subject to the claims of creditors. When setting up a viatical agreement, clients should make sure to include provisions protecting their privacy. Also, it is quite common for viators to receive less than they expect from a viatical agreement. The new owner will have no insurable interest in the life of the insured, a scenario that makes many insurance companies uneasy.
Basics of Key Employee Insurance Key employee insurance is insurance taken out on a certain valuable employee. This insurance is owned by the business, which is also considered the beneficiary. The premiums in a policy of this type are not deductible to the business. Death benefits acquired through a policy of this type are tax-free. Generally, key employee insurance is taken out in order to protect the business against the loss of business income and also to ensure that funds will be available to find and train a replacement for the key employee.
Insurance Needs Analysis Life Insurance Amount Required Financial planners may conduct a financial needs analysis to determine how much life insurance a family needs if the principal sum is liquidated in the process of meeting the client’s financial objectives for surviving members of the family. The liquidation approach (using investment earnings and capital) creates the risk of running out of funds prematurely, while the nonliquidation approach (using investment earnings only) may provide too small of a monthly income. A capital needs analysis (analysis of capital retention) doesn’t liquidate the lump sum principal received after death; it uses a high capitalization rate to derive income benefits solely from investment income. The human life value analysis method tries to determine what will be lost if a certain person should die; this is calculated as the present value of that person’s estimated future earnings that will be used to support future dependents. Disability, Long-Term Care, Health, Property, and Liability Insurance If a disabling injury should occur, the financial risk taken by the client is calculated as the difference between income needs and income sources. Individuals with no dependents will need disability insurance more than they need life insurance. Individuals probably need to achieve a minimum of wealth before they consider purchasing long-term care insurance, and most will wait until around age 60 to purchase it at all. When purchasing basic health insurance, individuals should be mainly conscious of protecting against the chance of catastrophic loss. Most purchasers of property insurance will accept the financial burden of small losses in order to avoid paying outrageous premiums. As for liability insurance, it is crucial that the limits be coordinated with homeowner and auto insurance in an umbrella policy.
Insurance Policy Selection Purpose of Coverage, Length of Time Required, Risk Tolerance, and Cash Flow Constraints The purpose of insurance is threefold: to protect existing assets; to protect income, so that it will not be interrupted by loss; and to protect both income and assets in the case of liabilities or emergency needs. Life insurance policies may be taken out for short-term needs, as when it is used to hedge a mortgage or a loan, or it may be taken out permanently, in order to augment or increase retirement income in the future. There are some basic assessments of risk tolerance that will determine the coverage appropriate for a given client: clients who are primarily seeking to invest may want a variable form of insurance; clients seeking to protect themselves should consider term insurance; clients who want flexible premiums should take universal and variable universal life; and clients mainly concerned about surviving dependents should take a joint or survivorship life policy. Families should always have enough disability and health insurance, even at the expense of life insurance.
Insurance Company Selection Financials and Ratios The most important factor used in evaluating an insurance company is financial strength, but customers should also consider the willingness and ability to pay claims, the number of lines of coverage offered, the service provided before and after a claim, the cost of the coverage, and the age of the company. Typically, companies that sell only life insurance will have more financial stability than those that offer a number of different types of insurance. Also, companies that mainly sell term insurance are likely to be less stable. The NAIC Watch List is a compilation of 12 financial ratios that measure the financial strength of insurers. The risk-based capital ratio measures the minimum amount of capital that an insurance company needs to maintain to support operations. The lapse ratio measures the number of policies that are cancelled. Policy persistency measures the relative longevity of policies. Ratings and Mutual vs. Stock These five companies provide the best ratings of financial strength: A.M. Best; Fitch; Moody’s; Standard and Poor’s; and Weiss. These ratings are typically based on underwriting results, economy of management, adequacy of reserves for undischarged liabilities, adequacy of policyholder’s surplus to absorb shocks, and the soundness of investments. In stock insurance companies, stockholders assume the risks of the insured, the premiums charged are nonnegotiable, earnings are distributed to shareholders as dividends, and the capital invested by shareholders creates a surplus to protect against emergency. In a mutual insurance company, policyholders own the company, premiums are not fixed, there are no dividends or capital stock, and the company must be sure to accumulate a surplus in case of emergency. Reinsurance and Investments Reinsurance is the insurance purchased by insurance companies. Reinsurance exists so that, in the event of catastrophic events, losses can be diversified. Also, reinsurers aid small insurance companies by removing part of the burden of accumulating reserves in case of emergency. When insurance companies receive premiums, they usually invest them, though state law strictly governs this process. Insurance companies that specialize in life insurance tend to make most of their investments in long-term securities, since they do not need to have highly liquid investments. Other companies are likely to invest more in government securities, since the insurance contracts they offer are of shorter duration. Underwriting, Federal Law, and State Law Underwriting is the process whereby insurance applications are selected and classified. This process obviously involves rejecting some applicants. Underwriting is performed at the time of the original application and at every subsequent renewal. Information for underwriting is obtained from the applicant, the agent, claims department, and other outside agencies. The government regulates insurance through legislation, judicial action, and administrative action. The NAIC drafted the McCarran-Ferguson Act of 1945, which gives the power to regulate insurance companies to states. The NAIC also can recommend legislation. Two common areas are solvency regulation (concerning the licensing of companies, regulation of reserves, etc.) and marketing regulation (concerning unfair practices, consumer complaints, etc.).
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